Rethinking China's Tight Monetary Policy

Facing so many variables -- credit control, price distortion, export pressure, and more -- should policymakers change course?

By staff reporters Zhang Huanyu, Li Zengxin, Zhao Hejuan, You Shanshan

Midway through what Premier Wen Jiabao called “the most difficult year,” China has now reached a critical point where economic planners must decide whether the tight monetary policy in place since December 2007 should be relaxed to prevent an economic downslide before 2009.



Against the backdrop of Beijing policies that tightened credit and forced banks to raise reserves, China's economic position has worsened since last year. It's facing weaker external demand tied to financial turmoil and economic slowdowns around the world, combined with soaring prices for energy and other inputs. Winter storms, an earthquake and floods made things worse. Industrial profits fell, the stock market turned bearish, and real estate sales slumped.

China's gross domestic product maintained a robust 10.4 percent growth rate in the first half, while growth in the consumer price index moderated to 7.9 percent, reflecting the tighter monetary policy. Yet GDP growth has been slowing. The rate was 10.6 percent in the first quarter, 0.7 percent below the same period 2007, and 10.1 percent in the second quarter.

Slower growth has been a natural consequence of the government's tightening. But a question remains: Is this an appropriate slowdown, or does it foreshadow a deep recession? To find an answer, policy orientation based on good judgment is needed during the second half of the year.

A heated debate now rages between those who think policymakers should shift the nation's priority to economic growth and ease credit controls, and others who say controlling inflation is still a top priority, given the variety of pressures pushing prices higher.

Beijing is seeking solutions. Premier Wen, Vice Premier Wang Qishan, Vice Premier Li Keqiang and other top ministers recently visited coastal provinces and municipalities to get a closer look at economic conditions. Meanwhile, a recent conference of the State Council Standing Committee emphasized the importance of maintaining stable economic growth and anti-inflation targets, slightly modifying the call to make “combating inflation a top priority” first heard at the beginning of the year.

Some think yuan appreciation may slow in the second half following a decline in China's trade surplus due to weaker export demand. And many believe export tax rebate rates for some products soon will be increased.

Tighter policy has effectively controlled inflation, and for now economic overheating is not a major threat, said Song Guoqing, a professor at Peking University's China Center for Economic Research. A moderate slowdown is a normal growth fluctuation, he said.

Mounting Challenges

Nevertheless, concern over the economy's current status is overshadowed by worries about future economic growth. The Shanghai Composite Index has plummeted in recent weeks to below 3,000 from a high of more than 6,000 last autumn, reflecting dim investor confidence in the profit potential of listed companies.

Industrial production slowed notably. The aggregate value added by upscale industrial enterprises grew 16.3 percent in the first half 2008, down 2.2 percent from the same period last year. Profit growth slowed significantly to 20.9 percent, down more than 21 points year-on-year.

Caijing learned that enterprises are experiencing major challenges stemming from rising prices for raw materials, labor and financing. Yuan appreciation is also a threat to corporate profitability.

A series of uncertainties will make it hard for industrial profits to gain momentum in the second half, said Gao Shanwen, chief economist with Essence Securities. The profit slowdown may extend into the first half of 2009, he said.

China is also at the mercy of weakening external demand. Recession risks continue to mount in the United States, where even institutional pillars such as Fannie Mae and Freddie Mac are in trouble. Statistics for the euro zone and emerging markets are worrisome as well, said Shen Jianguang, an analyst with Citic Securities.

A U.S. recession would spill into other countries, lowering demand for Chinese goods in many areas. Already, Chinese exports to Russia and South Asia countries are growing at slower rates, according to China International Capital Corp.

Macroeconomic policy is countercyclical. Tightening measures are designed to fight inflation at a cost of growth. But policymakers must be extremely cautious to avoid credit controls that are too tight and strangle small enterprises, experts warn.

What, then, is the proper speed for growth? Some speculate the country's 9.8 percent average annual growth rate for the past 30 years should be a bottom line. Others say lower rates are acceptable.

Tough Times for Enterprises

It's been reported that many coastal export manufacturers are already bankrupt, and that local financial institutions have been hit by bad loans. Because many small- and medium-sized enterprises (SMEs) in Zhejiang Province usually provide loan guarantees to each other, there may be a domino effect of insolvency, and the unofficial “civil” financing system could collapse.

There is no solid data on this civil financial system. After speaking with officials at dozens of SMEs in Zhejiang, Caijing reporters felt the situation may be better than many believe.

Cai Zhangsheng, administrative director of Zhejiang Small- and Medium-Sized Enterprise Bureau, criticized rumors about a large number of SME bankruptcies in his province. “There always have been new entrants and dropouts,” he explained.

Manufacturers in Guangdong Province agreed. Wu Hang, secretary of the Guangdong Association of Shoemakers, said that bankrupt companies “are mainly the less competitive ones.”

Still, research by the Economic and Trade Commission of Wenzhou, a major export city in Zhejiang, said 6.3 percent of the 23,570 surveyed enterprises in 26 industrial categories have suspended or partially suspended production.

Caijing learned that the closed SMEs in Wenzhou and Huzhou represent a small portion of the sector. Many factories that produce textiles, garments, shoes, hats and other light goods are small, family workshops. A daily list of closures and startups is normal. Workers cut loose by closures, especially in counties and villages, may quickly find jobs at bigger factories.

Nevertheless, SMEs have been squeezed by reduced loan opportunities. The government's tight monetary policy set strict loan quotas and “window guidance” that encouraged big banks to support large companies and government projects, leaving some SMEs to fend for themselves.

Meanwhile, a problem with excess investment has been exposed. According to the central bank, loans to Zhejiang companies grew 22 percent annually between 2003 and '07 -- far above the 16 percent national average. Apparently, they went too far.

Cai explained that companies in the province flush with cash have tended to increase investments and expand production, instead of enhancing management, upgrading product structures or improving risk and cost controls.

“They have invested too much in too many fields,” said an executive at a major shoemaker. “Once credit conditions are tightened, they have trouble raising funds.”

The good news is that total lending has not fallen since last year. So, because companies usually do most of their borrowing in the first half of the year, and credit has been tightly controlled in the past six months, loans may be easier to get in the second half. Thus, many experts see no reason for major credit control adjustments.

Distorted Inputs

Another key issue for Beijing policymakers concerns price controls. Since China's economic reforms began in 1978, price distortion has been never more serious. The situation has encouraged irrational economic behavior.

Consider coal prices paid by power generators. Government controlled prices have led to shortages of power -- and inefficiencies. Some power companies can make more money by reselling coal than generating electricity. In addition, low caps on industrial power prices effectively subsidize foreign producers and consumers. Domestic steelmakers, for example, export products made with cheap power after importing high-priced iron ore from abroad.

Other irrationalities can be found in the energy sector. For example, the smuggling of crude oil and oil products out of China is on the rise, encouraged by Chinese price controls. Freight transportation price controls give companies little incentive to increase fuel efficiency. Moreover, environmental costs are not built into corporate spending.

Such is the distorted fruit of price controls. Consumers, enterprises and foreign investors are taking advantage of low input prices. As a result, some companies survive with abnormally low spending levels, while others are reluctant to upgrade technology and product structures. As a result, China is home to excess investment, overcapacity and rapid GDP growth.

Controlled input prices and near-zero environmental costs have encouraged excessive investment, resulting in high resource consumption and environmental damage, said Xu Xiaonian, a professor with China Europe International Business School. The 10 percent GDP growth level is too high, he said.

“Raising resource and environment prices, and lifting salary standards, is a substitute to yuan appreciation,” said one analyst. Furthermore, he said, lifting price controls can be seen as a cost normalization process.

Inflation: Here to Stay

Here's another question: How would a price normalization process add to inflationary pressure? Lifting price controls can be expected to push prices even higher. “The key is to keep the money supply under control,” said Shen Mingao, Caijing's guest economist.

Excess liquidity has been blamed for inflation, while the trade surplus is said to be a major liquidity driver. To maintain a stable yuan exchange rage, the central bank -- the People's Bank of China -- buys with U.S. dollars, putting another 7 yuan into circulation for every dollar. To soak up trade surplus liquidity, the central bank raised the required reserve ratio for commercial banks six times this year to 17.5 percent, and continued issuing central bank bills. Now, there is less room for reserve hikes, and bill issues are less effective.

The central bank usually looks at curbing loan and M2 growth to control money supply. Some think the broader M3, which includes domestic loans plus foreign exchange assets, should be monitored as well. But as long as forex assets are seen as an “uncontrollable” external variable, the focus will remain on domestic loan growth.

There has been speculation in recent months that the central bank may soon raise interest rates for the first time this year. Some experts suggest raising rates while relaxing quantitative controls to test and filter out the most competitive companies.

However, risks have kept the central bank from making such a move. Higher rates attract more “hot money,” raising finance costs and adding interest burdens for real estate buyers. Therefore, the central bank is unlikely to raise interest rates this year.

“I hope for no further tightening, nor relaxing,” said Shen. “Stick to the original plan and there will be changes.”

Structural Transformation

Fortunately, some entrepreneurs have started to adjust. Years ago, Zhejiang and Guangdong provinces decided to encourage enterprise transformations based on a “rebirth” idea for private enterprises. Now, companies that find yuan appreciation and input price normalization trends irreversible have started shifting their focus to domestic sales from exports, or adding new products to existing production lines. A “manufacturing services” sector is also emerging.

Caijing found many merchants in the Zhejiang city of Yiwu talking about increasing exports to Russia, South Korea, the Middle East and European Union countries less affected by the sub-prime crisis. New language training courses are getting popular. Other SMEs have started shifting sales to the domestic market, said Zhou Wenbin, an official with the Yiwu Foreign Trade Bureau.

China's manufacturing sector has entered a “high-cost” period, said an entrepreneur from Zhejiang's city of Shaoxing. Primary product manufacturers are unable to transfer higher cost burdens to downstream enterprises by raising prices. These upstream companies have started selling on the domestic market or diverting to the import business to benefit from yuan appreciation.

Meanwhile, downstream SMEs with single and simple products are having more trouble than those with a long production chain. But in general, there are still obstacles preventing downstream private SMEs from acquiring companies in upstream industries such as energy and resources. If these sectors are open to private investment, SMEs will have more room and chances for structural transformation, many company officials said.

There is no doubt the process is painful and needs time. Some entrepreneurs expect a “convulsion” period to last until at least 2009. “Worries among these SMEs are right about the hope for industrial upgrades and economic structural transformation,” Xu said.

Pressure for Policy Adjustment

Faster yuan appreciation in the second half is less likely because policymakers have noticed falling export growth and enterprise failure problems. Slower appreciation also discourages inflows of short-term speculative capital. External pressures that promote a “hot money” influx in China may decrease, experts say, while internal inflation pressures remain.

Facing worsening export prospects, many experts suggest raising export tax rebates for several industries. As a result, the government reportedly may lift the rate for textiles by 2 percent and clothing by 4 percent.

However, Caijing found most of the interviewed company officials think such a raise would bring limited benefits to domestic producers. Some are even opposed.

If export rebate rates were now increased, after several cuts since 2007, Chinese exporters overall could be more competitive with companies in other countries, since lower production costs would lead to lower prices for customers. But companies catering to the domestic market would see little impact.

Some large companies prefer no adjustments, admitting their profit margins have been small. They hope for a “reshuffling” in their business fields, fearing a higher export tax rebate may bring small, low-cost and low-profit competitors back to the market.

But most Chinese textile and clothing makers are original equipment manufacturers whose products are sold abroad under brand names. Foreign buyers closely watch Chinese regulations, and they know immediately when export tax rebate rates change.

“You need to fight for a bigger share of profit brought by the 2 percent more rebates, and you may possibly get the smaller share,” said an official at one clothing maker, who expects Chinese companies profit less than one-fourth of the amount.

“If you don't give away the profit, another Chinese company may offer a lower price and take all your orders.”

Relaxing credit controls may help private SMEs with fund-raising troubles, company officials told Caijing. These include companies accustomed to loans from civil financing sources, whose bad debts cannot be resolved with commercial bank loans.

Some experts think that the second half of 2008 should be marked by initiatives that control the nation's money supply, relax price controls and cut tax burdens.

Money supply control would target aggregate demand and general price levels; releasing price controls refers to abolishing limits for input prices, especially coal, power and transportation; and cutting the tax burden is all about enhancing competitiveness by reducing payment obligations for companies.

Either a minor or a major makeover for the tight monetary policy in place since December could help China's economy survive --even prosper -- during the current global downturn, and into 2009. This has already been a difficult year, as the premier said, and it doesn't have to get worse.